Friday 29 Mar 2024
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This article first appeared in Forum, The Edge Malaysia Weekly on July 11, 2022 - July 17, 2022

The anticipated monetary policy tightening in developed economies is happening and it will continue until inflationary expectations are sufficiently tempered. The lesson learnt on the application of monetary policy is that if the trigger is pulled, it has to achieve the objective of dampening inflationary expectations as the cost of pulling the trigger is substantial. That signalling of commitment has to be clear. The cost-­benefit conclusion underlying this decision is that runaway inflation is a whole lot costlier to the economy compared to the short-term costs of pulling the trigger, that is, raising interest rates.

The US Federal Reserve’s aggressive inflation targeting has seen it sharply raising its policy rate by 0.75% in June. The Fed is expected to do the same this month and it will likely continue thereafter at a slower pace. It wants to bring inflation back down to its target of 2%; a monumental task given that it is now around 8%. It is doing this while the economy is growing rather robustly and studies have shown that the source of inflation in the US is about equally divided between supply constraints and demand-side push. The Fed is signalling that it is willing to sacrifice growth to achieve its inflation target, mindful that increasing rates will dampen demand.

Of course, the war in Ukraine — together with the disruptions arising from the sanctions imposed on Russia — have added another dimension to this inflation story, mainly from the supply side, something that will linger for a while even if the war ends. The demand side also saw a surge fuelled by the various fiscal initiatives in the form of Covid support programmes as well as the accompanying loose monetary stance that has not really normalised since the 2008 financial crisis. There is also the oddity that is China, which has not yet normalised from the Covid pandemic, thereby taking away quite a bit of wind on both the demand and supply sides of the global economy.

In any crisis, global ones especially, there is no uniformity to the phenomenon but a useful dichotomy is to separate the developed and emerging economies while mindful that there are also wide variations within each group. Europe, in particular, is facing a different set of circumstances compared with other developed economies. The common phenomenon globally is inflation that arose from a combination of supply shocks, a surge in demand that is accompanied by over a decade of loose monetary policy, and for many emerging economies, weakened currencies.

It has become somewhat of a normative debate on whether tightening monetary policy is the right response to contain inflation, but such tightening in developed economies has resulted in the outflow of funds from emerging economies. This has created another reason for inflation in emerging economies — the depreciation of their currencies, which punishes importers and is making economies without sufficient exports very vulnerable. This is especially so for economies that are also fiscally in deficit. Sri Lanka is an example of such an economy.

The Malaysian economy is about 1.5% the size of the US economy and the ringgit does not have the “exorbitant privilege” of the US dollar, so the analyses on how global changes affect the Malaysian economy will have to take them as exogenous and figure out how the economy will endogenise them and what the transmission mechanisms are.

On the real side of the economy, the current account, being a national accounting number, says a lot about the economy. It captures the balance of trade and, therefore, it is a snapshot of the production structure of the economy and the competitiveness of domestic firms as well as showing the flows of income. It gives the balance between savings and investments in the economy and therefore availability of funds in the country, an indicator that links households and firms on the real side of the economy to the capital markets.

Malaysia’s current account post-1998 crisis peaked in 2008 at 16.9% of gross domestic product, and it has been steadily declining ever since. At the end of the first quarter this year, the current account surplus was only slightly less than RM3 billion, less than 1% of GDP for the same quarter. These numbers fluctuate but the downward trend is well established. Should it continue, which is likely, we will find ourselves in a twin deficits situation, which means government borrowings will have to be part-financed externally. From an economic management perspective, nothing is worse than being afflicted with these twin deficits.

The economy has not had a current account deficit since before the 1998 financial crisis, but that was a period when public finances were healthy and in surplus. The last time the current account was in deficit, it was corporate Malaysia that borrowed heavily externally and growth was robust. The inflows of funds into the economy then buoyed the ringgit well above its fundamentals, deceptively mispricing debt. And when the bubble burst, everything unravelled. The 1998 crisis was essentially a currency crisis that resulted in a severe credit crunch.

The threat this time around will be the ability to borrow — which is the issue of liquidity — as well as the cost of borrowing, and the reality is that the government has to continue borrowing. We are in a period of weak and fragile growth with the currency weakening as funds have been flowing out, but unlike the Fed, Bank Negara Malaysia has been less decisive. Perhaps it is because the target variable, inflation, is technically low here, kept low, however, with huge fiscal resources. The coordination and inter-linkages between fiscal and monetary policies have become somewhat blurred. What is clear is that policy should instead focus on where policy levers can have some degree of influence — which means that monetary tools are the only tools with any efficacy to manage inflationary pressures coming from the currency weakening.

If this trend in the current account is juxtaposed with the trend in fiscal revenues, we get a disturbing picture because it confirms that without clear fiscal reforms to manage the extent of borrowing, the liquidity and cost risks from a current account deficit are very real. Federal government revenue as a percentage of GDP has declined from over 21% in 2012 to about 18% last year, with the tax-to-GDP ratio being around 12% in 2021 compared with 16.1% in 2012.

Of course, there is a greater demand on fiscal resources but the government has been lackadaisical in consolidating government expenditure, especially while also avoiding the pain of enhancing revenues. The state of government finances is a major point of vulnerability that can push an external shock into a national crisis.

On the private side of the economy, one can look at investments as an indicator of both confidence and the creation of new economic capacity. Investments as a share of GDP have been falling since the 1998 crisis — from a peak of over 40% in 1995 to just under 20% last year. This is happening while the current account surplus too is declining, which suggests that the surpluses the economy has been generating have not been reinvested. It has largely been sloshing in the capital market with the government being the dominant borrower there. This is a textbook crowding-out situation but there are also other reasons why private investments have been declining. Quite a few of those reasons are being amplified instead of being addressed by the current government.

Since the onset of the Covid pandemic, the government has not presented a coherent policy framework to address the longer-term structural problems facing the economy. The successive governments have been preoccupied with short-term problems — managing the pandemic in the face of severe fiscal constraints and doing it almost on an ad hoc basis; from securing the budget to fund vaccination and putting in place safety net programmes to managing the effects of food inflation.

The change in government almost a year ago did not change the policy posture much as the present government is essentially the same as the last one, a distracted one that is seemingly more preoccupied with its own political longevity than tackling the more substantive problems of the economy, including some potentially damaging time bombs mentioned earlier. Either the government is impervious to these challenges or it is just incompetent. It has instead focused on identity-based issues that are meant to address the political constituency instead of addressing the pressing problems faced by that same constituency.

I do not foresee any change to this political situation and I therefore do not foresee any positive changes to the way the economy is managed. From a purely economic point of view, there should be a general election as soon as possible to obtain clearer boundaries among political parties and the alliances between them. Fractious though the results may be, the business of diffusing these time bombs can get started. Time is not an ally for the economy. As long as political boundaries are firm, the equilibrium will be more stable than what it is today.


Dr Nungsari A Radhi is an economist

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